ANNUAL REPORT 2013

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2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013

ANNUAL REPORT

2013

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ANNUAL REPORT 2013

In 2014 all ECB publications feature a motif taken from the €20 banknote.

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© European Central Bank, 2014 Address

Kaiserstrasse 29 60311 Frankfurt am Main Germany

Postal address Postfach 16 03 19 60066 Frankfurt am Main Germany

Telephone +49 69 1344 0 Website

http://www.ecb.europa.eu Fax +49 69 1344 6000

Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

Photographs:

Andreas Böttcher Robert Metsch

The cut-off date for the data included in this report was 14 February 2014.

ISSN 1725-2865 (epub) ISSN 1725-2865 (online)

EU catalogue number QB-AA-14-001-EN-E (epub) EU catalogue number QB-AA-14-001-EN-N (online)

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ABBREviATiONS

COUNTRiES

BE Belgium BG Bulgaria CZ Czech Republic DK Denmark DE Germany EE Estonia IE Ireland GR Greece ES Spain FR France

HR Croatia IT Italy CY Cyprus LV Latvia LT Lithuania LU Luxembourg HU Hungary MT Malta NL Netherlands AT Austria PL Poland

PT Portugal RO Romania

SI Slovenia SK Slovakia

FI Finland SE Sweden

UK United Kingdom

JP Japan US United States

OThERS

BIS Bank for International Settlements CPI Consumer Price Index

EBA European Banking Authority ECB European Central Bank EEA European Economic Area

EIOPA European Insurance and Occupational Pensions Authority

EMU Economic and Monetary Union ESA 95 European System of Accounts 1995 ESCB European System of Central Banks ESMA European Securities and Markets

Authority

ESRB European Systemic Risk Board EU European Union

EUR euro

GDP gross domestic product

HICP Harmonised Index of Consumer Prices ILO International Labour Organization IMF International Monetary Fund MFI monetary financial institution NCB national central bank

OECD Organisation for Economic Co-operation and Development

PPI Producer Price Index

SSM Single Supervisory Mechanism

In accordance with EU practice, the EU Member States are listed in this report using the alphabetical order of the country names in the national languages.

Unless stated otherwise, all references in this report to Treaty article numbers reflect the numbering in effect since the Treaty of Lisbon entered into force on 1 December 2009.

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In 2013 monetary policy continued to operate in a challenging environment characterised by ongoing, albeit moderating, financial fragmentation in the euro area. Underlying price pressures receded further amid broad-based economic weakness and continued subdued monetary dynamics. At the same time, medium to longer-term inflation expectations remained firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2%

over the medium term, confirming the credibility of the ECB’s monetary policy strategy.

Over the course of 2013 the euro area economy emerged from recession as a result of a gradual revival in domestic demand – supported by an accommodative monetary policy stance as well as by improving economic and financial market sentiment – and stronger foreign demand.

However, the ongoing process of balance sheet adjustment in the public and private sector and high unemployment continued to dampen economic activity. Inflation declined perceptibly throughout 2013, reflecting, in particular, receding contributions from energy and food prices, as well as weaker underlying price pressures. On average, inflation stood at 1.4% in 2013, after 2.5% in 2012. The underlying pace of monetary growth remained subdued and loan growth continued to decline, mainly on account of weak credit demand, although adverse factors weighing on credit supply also played a role. In the light of a weaker inflation outlook extending into the medium term, the Governing Council lowered key ECB interest rates in May and again in November, reducing the rate on the main refinancing operations to 0.25%.

Throughout the first half of 2013 euro area money market interest rates displayed significant volatility. Money market interest rates, in particular at the longer end of the term structure, rose markedly towards mid-2013, reflecting shifting expectations regarding future monetary policy and spillovers from developments outside the euro area. In order to anchor market expectations of interest rates more firmly around a path warranted by the outlook for price stability over the medium term, the Governing Council provided forward guidance in July, announcing that it expected the key ECB interest rates to remain at their prevailing or lower levels for an extended period of time.

This message was confirmed over the remainder of the year, notably in the context of the November interest rate cut. In November the Governing Council decided that the Eurosystem would continue to provide liquidity to banks through fixed rate tender procedures with full allotment until at least mid-2015.

Financing conditions improved in 2013 amid an abating sovereign debt crisis on account of further fiscal consolidation, a reduction of macroeconomic imbalances particularly in vulnerable euro area countries, improved EMU governance and progress towards banking union. However, financial fragmentation along national borders persisted, particularly in credit markets. To ensure that monetary policy decisions are adequately transmitted to the real economy in euro area countries, it

FOREwORd

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is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed. This confidence-building process will be enhanced by the comprehensive balance sheet assessment conducted by the ECB before it adopts its supervisory role under the Single Supervisory Mechanism. Further decisive steps by governments to establish banking union will help to restore confidence in the financial system.

Euro area countries continued to make progress with fiscal consolidation in 2013. The average government deficit is expected to have declined to around 3% of GDP, after 3.7% in 2012. With the entry into force of the “two-pack” regulations in May 2013, the euro area governance framework was strengthened further. Euro area governments are now required to submit their draft budgetary plans to the European Commission each autumn for a review of their compliance with the EU fiscal rules. This obligation greatly enhances transparency and aligns the European surveillance calendar more closely with national budgetary procedures. In its review of the submitted draft budgetary plans in October, the Commission found most plans to be at least broadly compliant with the fiscal rules. However, it identified a risk of non-compliance for some countries and invited the respective authorities to adopt additional measures to ensure full compliance.

Looking ahead, it will be important not to unravel past efforts but to sustain fiscal consolidation over the medium term, not least because general government debt-to-GDP ratios remain at high levels. Fiscal strategies should be in line with the fiscal compact. They should ensure growth-friendly consolidation which combines improving the quality and efficiency of public services with minimising distortionary effects of taxation. Governments also need to push ahead with product and labour market reforms, in order to improve competitiveness, raise potential growth, generate employment opportunities and foster the adaptability of the euro area.

Market tensions continued to recede in the course of 2013, in an environment of improved investor confidence and easing funding conditions for euro area banks and sovereigns. In particular, excess liquidity in the banking system declined owing to repayments by various Eurosystem monetary policy counterparties of part or all of the amounts that they had borrowed in the three-year longer-term refinancing operations (LTROs) conducted in late 2011 and early 2012. The option of early repayment was first made available to the banks in January 2013, and they made extensive use of this possibility over the course of the year. These early repayments marked a shift in the banking system’s demand for liquidity buffers, which by the end of 2013 had returned to levels last seen in autumn 2011, before the allotment of the first three-year LTRO. The Eurosystem’s stock of securities held for monetary policy purposes declined during the year owing to redemptions and to the absence of additional purchases. Moreover, in 2013 the Governing Council took various decisions related to the collateral which is eligible for use in monetary policy operations. In particular, the eligibility criteria were adjusted and the risk control framework was further strengthened.

Turning to financial stability developments, against the background of a challenging but improving macroeconomic environment, euro area financial sector stress remained moderate in 2013.

Advances made on the regulatory front contributed to the building-up of higher capital and liquidity buffers in the banking sector, enhancing the banking system’s shock-absorption capacity and weakening the adverse feedback loops between banks and sovereigns.

The financial performance of large banking groups in the euro area remained subdued in the first three quarters of 2013, hampered by sluggish revenue growth and still elevated loan loss provisioning charges, which appear to be closely linked to the economic cycle and have been

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particularly pronounced for banks in stressed countries. Despite relatively weak profitability, euro area banks have continued to steadily strengthen their capital positions. These improvements by euro area banks have been achieved through a combination of capital increases and reductions in risk-weighted assets, with the relative contribution of these two factors varying greatly across banking groups.

Conditions in bank funding markets improved, but fragmentation remains. Euro area banks’

issuance of both senior unsecured and covered bonds remained below 2012 levels, even though average bank funding costs reached their lowest level for more than three years across all major debt instruments in early October. The funding situation of banks benefited from continued deposit inflows in most countries, including some reversal of the fragmentation that had previously exerted a negative effect on deposits in some countries under stress. Moreover, banks in most stressed countries continued to reduce their dependence on central bank funding.

Notwithstanding these advances, ongoing efforts are needed to remove the risk of further negative interactions, at the country level, among stressed sovereigns, diverging economic growth prospects and bank fragility. Further progress towards establishing banking union will make an important contribution to overcoming these hurdles.

A major step towards enhancing the resilience of the financial system in the EU was taken in 2013 with the implementation of the new international standards of the Basel Committee on Banking Supervision on capital and liquidity (Basel III) in the EU through the Capital Requirements Regulation and Directive (CRR/CRD IV). The provisions of the Regulation are directly applicable in all Member States as of 1 January 2014. They form a “single rulebook” for financial regulation and supervision across the EU, thus ensuring equal regulatory treatment of institutions providing financial services in the Single Market and enhancing financial integration in Europe. The Single Supervisory Mechanism (SSM) will also rely on the single rulebook, which will ensure the harmonised application of rules within the euro area and in other Member States participating in the SSM. The SSM will become operational in November 2014.

The Single Resolution Mechanism (SRM) will be the next step towards banking union.

The European Commission proposed legislation in July 2013 which foresees a single European authority and a single bank resolution fund for all EU Member States that participate in banking union. The entry into force of the regulation is envisaged in mid-2014, and the SRM should become fully operational from 2015.

The SSM together with the SRM will help to break the link between banks and sovereigns in participating Member States and reverse the current process of financial market fragmentation.

An effective SRM also requires a comprehensive set of enforceable tools and powers, as provided for in the Bank Recovery and Resolution Directive (BRRD), on which agreement was reached between the European Parliament, EU Member States and the European Commission on 12 December 2013. The BRRD is expected to enter into force in 2015, and the bail-in tool will be effective as of 1 January 2016 at the latest.

In 2013 the European Systemic Risk Board (ESRB), the EU body responsible for the macro-prudential oversight of the EU financial system, devoted significant resources to further developing the macro-prudential policy framework, resulting in particular in the ESRB Recommendation on intermediate objectives and instruments of macro-prudential policy of

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4 April 2013. The introduction of the CRR/CRD IV regulatory package for the EU banking sector also called for a series of preparatory and implementing measures by the ESRB, which were carried out in cooperation with ESRB members. In July 2013 the ESRB published a handbook on the follow-up to its recommendations, which was first used to assess the implementation of the ESRB Recommendation on lending in foreign currencies. The results of the assessment showed that Member States had complied well with the Recommendation. Furthermore, the review of the European System of Financial Supervision (which includes the ESRB) is ongoing.

In the area of payment systems and financial market infrastructures, the ECB continued to contribute to the key policy and regulatory initiatives aimed at enhancing the stability of market infrastructures, including legislative initiatives at the EU level. The ECB also contributed to the work of the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, in particular with respect to the Principles for Financial Market Infrastructures and the resolution and recovery of such infrastructures, as well as to work in the field of over-the-counter derivatives market infrastructures. Furthermore, in the area of retail payments oversight, the Eurosystem defined oversight expectations for links between retail payment systems, and the Forum on the Security of Retail Payments developed security requirements for payments over the internet.

The ECB also continued to facilitate the creation of an integrated European retail payments market, and a significant proportion of euro direct debits and credit transfers are now SEPA-compliant.

An important milestone in the TARGET2-Securities (T2S) project was reached in 2013, as the work on developing the software for T2S was completed. A testing phase is now under way to ensure that the T2S platform starts operating in June 2015 as scheduled. Agreement was also reached on the dates for the migration of central securities depositories (CSDs) and their users to T2S, which will take place in four waves between June 2015 and February 2017. The total number of CSDs participating in T2S increased to 24, as two further CSDs signed the T2S Framework Agreement.

The continual growth of the T2S community demonstrates the significant impact that T2S will have on the post-trade infrastructure in Europe.

Turning to organisational issues, the ECB had 1,907 full-time equivalent permanent positions at the end of 2013, compared with 1,450.5 positions at the end of 2012. The increase is mainly due to positions approved in 2013 in relation to the establishment of the SSM. In accordance with the ECB’s mobility policy, 308 members of staff moved internally to other positions in 2013, while 12 members of staff were seconded to other organisations for external work experience and 62 were granted unpaid leave to study or take up employment with another organisation, or for personal reasons. In 2013 the ECB’s human resources strategy focused on working culture, gender diversity, recruitment, professional development and employment conditions. One of the main developments in the area of HR policies was the implementation of a gender diversity action plan designed with the aim of doubling the share of women in high-ranking positions at the ECB in the medium term.

Work on the new ECB premises neared completion in 2013, with the double office tower reaching its final height of 185 m in March. By the end of the year, good progress had been made on the technical infrastructure and fit-out of the standard office floors. The entrance building took shape and now clearly marks the main entrance to the ECB. Restoration works on the Grossmarkthalle roof and west wing progressed. The relocation of ECB staff is planned for the second half of 2014.

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Regarding its financial accounts, the ECB earned a surplus of €1,440.2 million in 2013, compared with a surplus of €2,161 million ¹ in 2012. The Governing Council decided to transfer, as at 31 December 2013, an amount of €0.4 million to the provision for foreign exchange rate, interest rate, credit and gold price risks, thereby increasing it to its ceiling of €7,529.7 million, which was the value of the ECB’s capital paid up by the euro area NCBs as at that date. The size of this provision is reviewed annually. The ECB’s net profit for 2013, following the transfer to the provision, was €1,439.8 million. The remaining amount of €1,430.3 million was distributed to the euro area NCBs in proportion to their paid-up shares in the ECB’s capital.

Frankfurt am Main, March 2014

Mario Draghi

1 As restated owing to a change in accounting policies.

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In 2013 visible progress was made on the construction of the new ECB premises. The structural works for all of the new building elements were completed in the spring and the concrete shells of the Grossmarkthalle’s roof had been fully restored by the end of the year. The interior of the large market hall has now also taken on a new splendour.

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ChAPTER 1 ECONOmiC dEvELOPmENTS ANd mONETARy POLiCy

1 mONETARy POLiCy dECiSiONS

ThE mONETARy POLiCy ENviRONmENT imPROvEd BUT REmAiNEd ChALLENgiNg

In 2013 the Eurosystem conducted its monetary policy in an environment which remained challenging, despite improvements in economic confidence, financial market sentiment and financing conditions. The level of stress in financial markets had been easing since the summer of 2012 on the back of the non-standard monetary policy measures undertaken by the ECB, the reform efforts made in several euro area countries, and progress towards a stronger euro area economic governance framework. Funding constraints for euro area banks continued to ease over the course of 2013, including for financial institutions in stressed countries. At the same time, a substantial degree of financial market segmentation along national borders persisted. Overall, while financial fragmentation continued to recede in the course of 2013, it remained elevated, resulting in significant heterogeneity in financing conditions for households and firms across euro area countries.

The ongoing process of balance sheet adjustment in the financial and non-financial sectors, combined with high unemployment and ongoing fiscal consolidation, continued to dampen economic activity in the euro area in 2013. At the same time, receding financial market tensions, improving economic confidence and a pick-up in foreign demand allowed output to stabilise in the second quarter after six quarters of contraction. The recovery, which gradually took hold over the second half of the year, also encompassed domestic demand. For the year as a whole, real GDP nonetheless declined by 0.4%.

Average annual HICP inflation stood at 1.4% in 2013 – with inflation declining perceptibly over the course of the year from 2.2% in December 2012 to 0.8% in December 2013 – as compared with the annual average of 2.5% in 2012. Low euro area inflation rates mainly reflected a strong decline in energy and food price inflation. The outlook for inflation was also revised downwards during the year in a context of weak economic activity. At the same time, medium and long-term inflation expectations remained firmly anchored at levels consistent with the Governing Council’s aim of keeping inflation rates below, but close to, 2% in the medium term.

Monetary and, in particular, credit dynamics remained subdued throughout 2013. M3 growth overall weakened in the course of the year, reaching an annual average rate of 2.4%, as compared with 3.1% in 2012. Loans to the private sector contracted again during 2013, reflecting in particular net redemptions of loans to non-financial corporations. To a large extent, subdued loan dynamics reflected the weak economic situation and outlook, heightened risk aversion and the ongoing adjustment in the balance sheets of households and enterprises, all of which continued to weigh on credit demand. Furthermore, in a number of euro area countries, pressure on banks to further deleverage remained high. Despite substantial improvements in the funding situation of banks since the summer of 2012 and an increase in economic confidence, credit supply continued to be restricted by capital constraints, the segmentation of financial markets and risk perception.

dimiNiShEd iNFLATiONARy PRESSURES LEd TO TwO FURThER CUTS iN kEy ECB iNTEREST RATES To ensure price stability in an environment of low underlying price pressures over the medium term, and to support the gradual economic recovery, the Governing Council cut key ECB interest rates twice in the course of 2013. In May it cut the interest rate on the main refinancing operations

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by 25 basis points and the interest rate on the marginal lending facility by 50 basis points. In November, given the overall subdued outlook for inflation extending into the medium term, the Governing Council cut both the interest rate on the main refinancing operations and the interest rate on the marginal lending facility by a further 25 basis points. Policy rates were then kept at their historically low level of 0.25% for the main refinancing rate, 0.00% for the rate on the deposit facility and 0.75% for the rate on the marginal lending facility for the remainder of the year (see Chart 1). The Governing Council confirmed that the ECB’s monetary policy stance would remain accommodative for as long as necessary, given its expectations of a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2%

later on.

In order to anchor market expectations of future policy interest rates more firmly around a path warranted by its assessment of the outlook for price stability over the medium term, the Governing Council decided in July 2013 to provide forward guidance, stating that it expected the key ECB interest rates to remain at their prevailing or lower levels for an extended period of time (see Box 1). It confirmed this message over the remaining months of the year. The Governing Council’s expectations continued to be based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics.

Box 1

ThE ECB’S FORwARd gUidANCE

On 4 July 2013 the Governing Council of the ECB announced that it expected the key ECB interest rates to remain at present or lower levels for an extended period of time. The expectation of the Governing Council was based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics. This communication provided a form of forward guidance on the monetary policy orientation of the Governing Council, conditional on the assessment of risks to price stability.

Following the initial announcement, the forward guidance provided in July was confirmed in its original formulation throughout the second half of the year. Notably, forward guidance was reasserted after the monetary policy decisions of 7 November 2013, which were taken in full consistency and continuity with that formulation. This box reviews the objectives, the design and the market impact of forward guidance.

Chart 1 ECB interest rates and the overnight interest rate

(percentages per annum; daily data)

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0

2008 2009 2010 2011 2012 2013

interest rate on the main refinancing operations interest rate on the marginal lending facility interest rate on the deposit facility overnight interest rate (EONIA)

Sources: ECB and Thomson Reuters.

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Objectives

The Governing Council’s decision to provide forward guidance was motivated by the need to align more firmly market expectations concerning the future evolution of the key ECB interest rates with the Governing Council’s conditional policy orientation. The decision taken by the Governing Council on 4 July came after a period in which euro money market interest rates had been rising consistently and had become more volatile. This market trend had led to a situation in which the accommodation introduced earlier through policy action had effectively been reduced.

Moreover, the increased volatility in money market rates had made expectations of the effective stance overly sensitive to shocks that were disconnected from the underlying economic and monetary conditions of the euro area. In addition to shifting market expectations regarding future monetary policy decisions and changes in the expected future path of excess liquidity, spillovers from developments originating outside the euro area were a key factor driving money market rates at that time. In these circumstances, more precise communication about the monetary policy orientation of the Governing Council was aimed at promoting steadier money market conditions and anchoring market expectations about future policy rates more firmly around a path warranted by the Governing Council’s assessment of the outlook for price stability over the medium term.

Design

The Governing Council’s forward guidance, in full accordance with the ECB’s mandate and its monetary policy strategy, was designed around three main elements.

First, the Governing Council’s expected path for the key ECB interest rates was based on the medium-term outlook for inflation, in line with the ECB’s primary objective to maintain price stability. Second, the extended period of time referred to by the Governing Council was a flexible horizon which did not pre-specify an end-date but was conditional on the Governing Council’s assessment of the economic and monetary developments that determine the outlook for price stability. Third, the underlying conditions upon which the expectations regarding the key ECB interest rates were based reflected the ECB’s approach to organising, evaluating and cross-checking the information relevant for assessing risks to price stability. In particular, this approach comprises the analysis of both economic and monetary developments, which provides a robust assessment of the medium-term outlook for price stability.

Notably, the Governing Council decided to provide forward guidance before having exhausted the potential for further reductions in key ECB interest rates. By reducing uncertainty around the expected path of future interest rates, forward guidance can provide a firmer control over market expectations independently of the prevailing stance of monetary policy. In fact, the ECB’s forward guidance entailed the possibility to reduce key ECB interest rates further if warranted by the evolving outlook for price stability. The Governing Council’s decision of 7 November 2013 to lower the interest rate on the main refinancing operations of the Eurosystem and the rate on the marginal lending facility, while leaving the deposit facility rate unchanged, was thus consistent with the conditionality of the 4 July statement. The confirmation of forward guidance after the November monetary policy decisions contributed to amplifying the accommodative impact of the interest rate reduction by facilitating its transmission to longer-term money market rates and to a broad set of financial market conditions.

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Market impact

The announcement of forward guidance on 4 July 2013 led to an immediate flattening of the money market curve (see Chart A), with forward rates declining by around 5 basis points at maturities of more than six months. In the months following the introduction of forward guidance, however, the forward curve started to steepen, reflecting positive economic news and data releases within and outside the euro area. The slope of the forward curve reached a new high in September, before flattening in a sustained manner, notably as a consequence of the November monetary policy decisions.

In parallel, forward guidance has led to a lasting decline in market uncertainty about the path of future short-term interest rates. Implied densities extracted from EURIBOR options show that the dispersion of short-term rate expectations has declined visibly from the elevated levels observed in June to a level closer to that observed in early May 2013 (see Chart B). On 2 May, after the Governing Council had reduced key ECB interest rates, market expectations of future interest rates one year ahead were concentrated around low levels. Thereafter uncertainty about future money market rates increased. With greater probability attached to higher levels, the mean expectation also increased, reaching its peak on 24 June. The forward guidance announcement subsequently led to a renewed narrowing of the dispersion of market expectations towards lower interest rate levels, accompanied by a downward shift in the mean expectation.

Chart A EONiA forward rates

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2 May 2013 (after interest rate cut)

3 July 2013 (before Governing Council meeting) 4 July 2013 (after Governing Council meeting) 5 September 2013 (after Governing Council meeting) 14 February 2014

2013May May

2014 May

2015 May

2016 May

2017 May

2018 Sources: Thomson Reuters and ECB calculations.

Note: Data as at end of day.

Chart B Uncertainty about future short-term money market rates

0.0 3.0

2.0

1.5

1.0

0.5

0.0 3.0

2.5 2.5

2.0

1.5

1.0

0.5

1.00 0.75 0.50 0.25 0.00 -0.25 -0.50

2 May 2013 (after interest rate cut) 24 June 2013

4 July 2013 (after Governing Council meeting) 14 February 2014

y-axis: density x-axis: interest rate

Sources: NYSE Liffe, Thomson Reuters and ECB calculations.

Note: Option-implied density of three-month EURIBOR in 12 months’ time applied to three-month overnight index swap rate in 12 months’ time.

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Overall, the evidence suggests that forward guidance has helped to provide greater clarity and transparency with regard to the Governing Council’s policy intentions, conditional on the evolving outlook for price stability. It also appears to have contributed to more stable money market conditions and to have anchored expectations more firmly. Therefore, forward guidance has successfully supported the ECB in the pursuit of its mandate to maintain price stability in the euro area over the medium term.

Against the background of the monetary policy measures adopted throughout the year, the Governing Council considered that price developments remained in line with price stability over the policy-relevant horizon in an environment of weak economic growth, well-anchored medium- term inflation expectations and subdued monetary dynamics. Risks to the outlook for price stability were seen to be broadly balanced.

NON-STANdARd mONETARy POLiCy mEASURES AdOPTEd iN 2013

Substantial early repayments of the three-year longer-term refinancing operations (LTROs) conducted in late 2011 and early 2012 meant a reduction in excess liquidity which, given remaining tensions in funding markets for banks, exerted some upward pressure on money market rates. To continue to ensure that solvent banks would not face liquidity constraints, especially once the three- year LTROs matured, the Governing Council announced in November 2013 that the Eurosystem would continue to provide liquidity to banks through fixed rate tender procedures with full allotment in all refinancing operations until at least 7 July 2015.

mONETARy POLiCy TRANSmiSSiON imPROvEd BUT REmAiNEd UNEvEN ACROSS COUNTRiES

The effects of the two cuts in key ECB interest rates in 2013 as well as of forward guidance worked directly through term money market rates as there was little scope for a further reduction in overnight rates: for most of 2013 excess liquidity kept very short-term rates close to the rate on the deposit facility (which had been reduced to 0.00% in July 2012).

The non-standard monetary policy measures adopted in 2011 and 2012 continued to contribute to a more effective transmission of the ECB’s interest rate measures in 2013. These non-standard measures included the two three-year LTROs conducted in late 2011 and early 2012, and the announcement by the Governing Council in the summer of 2012 of its readiness to undertake Outright Monetary Transactions (OMTs) in secondary markets with regard to sovereign bonds in the euro area.¹ The measures helped to alleviate tensions in financial markets and reduced tail risks and uncertainty. They thereby contributed to a sustained improvement in financing conditions, evidenced, for example, by a continued decline in the government bond yields of countries under stress and the issuance of new bonds by banks, companies and sovereigns which for some time had not had access to markets.

1 In order to address severe distortions in the pricing of sovereign debt in some euro area countries, in particular related to unfounded concerns on the part of investors about the reversibility of the euro, the Governing Council announced in August 2012 its readiness to undertake OMTs in secondary markets with regard to sovereign bonds in the euro area. OMTs had not been activated by the end of 2013, but the Eurosystem remains ready to undertake them under certain conditions (outlined in detail in Section 1.1 of Chapter 2 of the ECB’s Annual Report 2012). The Governing Council will independently consider conducting OMTs to the extent that they are warranted from a monetary policy perspective in the event of market fragmentation (subject to the aforementioned conditions). OMTs are aimed at supporting the transmission mechanism in all euro area countries and the singleness of the monetary policy. They provide a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.

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Although bank lending rates for households and non-financial corporations generally decreased at the euro area level in 2013, reflecting the pass-through of the cuts in key ECB interest rates as well as the improvement in financial market conditions, cross-country heterogeneity remained high. The lingering fragmentation of financial markets along national borders continued to hinder an even transmission of monetary policy in the euro area. As a result, the cuts in policy rates were largely passed on in some countries, but the interest rates charged on bank loans to the real economy decreased only slightly in other countries.

In order to ensure the adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed. The ECB’s comprehensive assessment of banks’ balance sheets before it adopts its supervisory role under the Single Supervisory Mechanism will further support this confidence-building process. It will enhance the quality of information available on the condition of banks and result in the identification and implementation of necessary corrective actions. Further decisive steps to establish banking union will help to restore confidence in the financial system. However, the root causes of the crisis are still to be fully addressed. In this context, governments should maintain their efforts to reduce deficits and sustain fiscal adjustment over the medium term. They should also decisively strengthen efforts to implement the needed structural reforms in product and labour markets to make their economies more competitive, and continue to improve the institutional setting of EMU.

2 mONETARy, FiNANCiAL ANd ECONOmiC dEvELOPmENTS

2.1 ThE gLOBAL mACROECONOmiC ENviRONmENT gLOBAL RECOvERy CONTiNUEd AT A SLOw PACE iN 2013

The global economy continued to grow at a modest pace in 2013, with the recovery slowly gaining some traction yet remaining fragile and heterogeneous across countries as the year progressed.

In the early part of the year, survey indicators signalled sustained momentum in global economic growth, with the Purchasing Managers’ Index (PMI) for global all-industry output hovering slightly above 52.9, the average in the final quarter of 2012. The continuous strengthening of business sentiment, albeit from low levels, along with improved global financial conditions, pointed to a gradual recovery in advanced economies and more solid growth in emerging market economies.

The data releases for the final quarter of 2012 and the first half of 2013 largely confirmed the pattern of continuing global recovery, which, however, remained muted and uneven. In advanced economies, growth stabilised in the first half of 2013, while in emerging market economies, contrary to expectations of gathering momentum, economic activity slowed again after rebounding at the end of 2012.

As the year unfolded, a number of negative surprises in both sentiment and hard data underscored the fragility of the recovery and the uncertainty surrounding the global outlook. In May the suggestion by the Chairman of the US Federal Open Market Committee of the likelihood that the Federal Reserve System would be tapering its asset purchase programme triggered a period of heightened uncertainty and renewed volatility in global financial markets. These developments resulted in tighter financing conditions, particularly for some emerging market economies, and a

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significant sell-off in global financial assets. Box 2 discusses the role of country vulnerabilities in the repricing of risk in emerging market economies and reviews the euro area’s exposure to these economies. The tightening of global financial conditions during the summer, coupled with weaker domestic demand and a still subdued external environment, weighed on activity in emerging market economies, weakening their short-term growth prospects.

In the second half of 2013 a gradual shift in growth dynamics in favour of advanced economies was observed. The pace of growth steadily firmed in most major advanced economies, although their medium-term prospects continued to be restrained by ongoing balance sheet repair, fiscal consolidation, relatively tight credit conditions and weak labour markets. Meanwhile, growth in a number of large emerging market economies lost some vigour, also owing to structural impediments, but remained robust compared with that in advanced economies and contributed significantly to global economic activity. Social unrest and geopolitical tensions in a number of Middle Eastern and North African countries also stifled growth.

Overall, global growth momentum remained slow, wavering and persistently divergent across countries. By the end of the year, however, data releases and survey indicators were both showing tentative signs of a gradual firming of global economic activity. The normalisation of global financing conditions in the second half of the year, after the adoption of forward guidance policies by the ECB and the Bank of England and the US Federal Open Market Committee’s decision to taper its asset purchases at a measured pace, seems to have removed some market uncertainty and supported global growth dynamics (see Chart 2).

World trade picked up from the very low levels recorded during the second half of 2012 but continued to be characterised by moderate and volatile quarterly growth. Following several months of solid readings in the first half of 2013, short-term trade indicators weakened again at the end

Chart 2 gdP growth and inflation in major economies

United States United Kingdom euro area

Japan China

Output growth¹⁾

(annual percentage changes; quarterly data) Inflation rates²⁾

(annual percentage changes; monthly data)

-10 -5

0 5 10 15

-10 -5 0 5 10 15

2008 2009 2010 2011 2012 2013 4

2 0 2 4 6 8 10

4 2 0 2 4 6 8 10

2008 2009 2010 2011 2012 2013

Sources: National data, BIS, Eurostat and ECB calculations.

1) Eurostat data are used for the euro area and the United Kingdom; national data are used for the United States, China and Japan. GDP figures have been seasonally adjusted.

2) HICP for the euro area and the United Kingdom; CPI for the United States, China and Japan.

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Box 2

imPLiCATiONS FOR ThE EURO AREA OF ChANgiNg FiNANCiAL CONdiTiONS iN EmERgiNg mARkET ECONOmiES

In 2013 significant changes in financing conditions were witnessed across a number of countries.

Emerging markets were particularly affected, as an episode of risk repricing that had already been observed in some of these countries in early 2013 was amplified by the US Federal Reserve System signalling in May that it might taper its asset purchase programme later in the year.

The vulnerability of some emerging economies to changes in global investor sentiment became exposed when their asset markets and currencies underwent considerable corrections, resulting in a tangible tightening of the financing environment with negative repercussions on their growth dynamics.

Against this background, this box attempts to gauge potential negative implications for the euro area of the deterioration in economic and financial conditions in emerging markets. It finds that the emerging markets most susceptible to the risk reassessment that took place during 2013 are characterised by significant domestic and external vulnerabilities. The euro area’s exposure to these latter countries via various transmission channels is relatively limited.

The role of vulnerabilities in the repricing of emerging market risk

Following a global sell-off of emerging market assets immediately after the Federal Reserve System’s announcement in May 2013, investors adopted a more nuanced stance over the of the summer, before recovering in the last months of the year. Overall, the volume of world imports of goods grew by an average of 0.8% quarter on quarter in the first three quarters of 2013, compared with 0.4% in 2012, gaining more vigour from September onwards, according to data from the CPB Netherlands Bureau of Economic Policy Analysis. At the end of 2013 all available short-term trade indicators pointed to a more sustained recovery in global trade, with the PMI new export order index recording its highest values since March 2011. Nevertheless, trade momentum is expected to remain subdued and below its pre-crisis levels in the near term.

Regarding price developments, the slowdown in global inflation that has been observed since 2011 continued in 2013, although it masked mixed developments across countries. A number of factors, including muted commodity price dynamics and weak global economic activity, as reflected in still ample global spare capacity and high unemployment, ensured that inflationary pressures remained contained. In the OECD area, average headline consumer price inflation fell to 1.6% in 2013, from 2.2% in 2012, largely driven by lower energy and food prices. The decline was broadly based across advanced economies, with the exception of Japan, where inflation rose (see Chart 2). Average OECD consumer price inflation excluding food and energy fell to 1.5% from 1.8% in 2012. Rates of inflation varied more among emerging market economies over the course of the year. Annual inflation rates were relatively modest in China but remained elevated in some other large emerging market economies. The weak global and domestic environment, coupled with moderations in food and energy prices, helped to dampen price increases, although currency depreciation from the middle of the year increased inflationary pressures in some emerging market economies.

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remainder of the year. Their focus shifted to countries that were perceived to be particularly vulnerable to possible further disruptions to capital flows, which resulted in additional declines in the latter’s equity, bond and currency markets. Countries with significant domestic and/or external imbalances, such as Brazil, India, Indonesia, South Africa and Turkey, therefore generally saw the largest deterioration in their financing environment.

Investor perceptions of domestic or external vulnerabilities of this group of countries are substantiated by a range of indicators. These economies stood out at the end of 2012 as being potentially susceptible to a worsening of global funding conditions (see the table). Turkey exhibited domestic vulnerabilities, such as very strong credit growth, and external imbalances, above all a substantial current account deficit largely financed by short-term portfolio flows and an unfavourable ratio of short-term external debt to foreign exchange reserves. India, South Africa and – to a lesser extent – Brazil and Indonesia had twin (fiscal and current account) deficits. These were combined in the latter three countries with a dependence on volatile portfolio investment (South Africa) or excessive credit growth (Brazil and Indonesia). However, some economies that seem to have been equally vulnerable on the basis of the same metrics were generally less affected by global market volatility. This points to the relevance of other factors shaping investors’ views on emerging economies, such as exposure to a slowdown in Chinese output, the capacity to benefit from the gradual recovery of economic activity in the euro area or the vigour with which governments have addressed existing imbalances, for example by implementing fiscal consolidation or structural reforms.

Selected indicators of external and domestic vulnerabilities

External indicators Domestic indicators

Current account

balance Portfolio

inflows¹⁾ Short-term

external debt Total external

debt Fiscal balance Credit-to-GDP gap²⁾ (as a percentage

of GDP) 2012

(as a percentage of total capital inflows) 2010-12

(as a percentage of foreign reserves) 2012

(as a percentage of GDP)

2012

(as a percentage of GDP) 2012

(percentage points)

2012

Czech Republic (CZ) -2.4 36.0 58.3 50.5 -4.4 n. a.

Hungary (HU) 1.7 -48.3 83.0 130.3 -2.0 -16.5

Poland (PL) -3.5 53.4 97.6 74.4 -3.9 1.0

Romania (RO) -4.4 45.7 121.8 75.7 -2.5 n. a.

Russia (RU) 3.7 6.2 32.7 28.6 0.4 -2.7

Turkey (TR) -6.1 41.8 147.7 42.8 -1.6 11.7

China (CN) 2.3 7.3 17.6 9.0 -2.2 13.4

India (IN) -4.8 22.9 44.3 21.2 -8.0 3.4

Indonesia (ID) -2.7 34.2 50.7 29.4 -1.7 12.8

Malaysia (MY) 6.1 63.8 39.1 27.1 -4.5 5.5

South Korea (KR) 3.8 88.7 39.4 36.2 1.9 3.4

Taiwan (TW) 10.5 n. a. 28.8 27.5 -4.3 n. a.

Thailand (TH) 0.0 29.6 41.6 36.4 -1.7 26.2

Argentina (AR) 0.0 14.0 272.9 32.0 -4.3 2.9

Brazil (BR) -2.4 24.8 21.3 14.1 -2.7 10.2

Mexico (MX) -1.2 66.0 67.3 29.2 -3.7 3.4

South Africa (ZA) -6.3 54.6 79.6 35.8 -4.8 -4.9

Sources: IMF, BIS, national sources, Haver Analytics and ECB calculations.

1) Portfolio investment liabilities incurred in the period 2010-12 as a percentage of all (foreign direct, portfolio and other) investment liabilities incurred.

2) Deviation of the credit-to-GDP ratio from its one-sided (real-time) long-term trend. Data for Argentina, Mexico and South Africa refer to the first half of 2012.

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Euro area exposure to vulnerable emerging markets

The direct transmission to the euro area of deteriorating economic and financial conditions in emerging markets is likely to be relatively contained. The euro area’s trade and financial ties with most emerging economies are fairly limited, a few noteworthy exceptions notwithstanding (see the chart). Moreover, its exposure to individual emerging markets is generally highest for countries which seem to have been least affected by global financial developments in 2013.

However, besides direct implications for the euro area of slower growth in emerging markets, indirect effects may also play a role. For example, a fall in commodity prices as a result of lower demand from emerging economies could improve the euro area’s terms of trade, although it might also put additional downward pressure on inflation. Furthermore, euro area foreign demand might be affected via indirect trade linkages if a slowdown in output growth in emerging markets were to affect economic activity in the euro area’s major trading partners among the advanced economies.

Looking at financial linkages in more detail, euro area portfolio investment in emerging economies is negligible. According to data from the IMF’s Coordinated Portfolio Investment Survey, Brazil, China, Poland and South Korea are the only countries where the euro area’s share of total portfolio assets held abroad is over 1.0%. Cross-border bank claims, while mostly more significant than portfolio flows, predominantly involve certain countries in central and eastern Europe (such as Poland with 4.0% of total claims and the Czech Republic with 3.0%) and Latin America (particularly Brazil with 3.6% and Mexico with 2.8%). As regards trade linkages, emerging market countries in close proximity to the euro area generally feature most prominently, with merchandise exports to Poland (5.1%), Russia (4.7%), the Czech Republic Euro area exposure to emerging market economies¹⁾

(percentages of total exposure)

0 1 2 3 4 5 6 7 8

PL CN RU CZ BR TR MX HU KR RO IN ZA MY ID TH AR TW

merchandise exports²⁾ cross-border bank claims³⁾ portfolio assets⁴⁾

Sources: IMF, BIS and ECB calculations.

Notes: Merchandise export data are unavailable for Taiwan. For country abbreviations, see the table above. Countries in the chart are ranked according to the sum of euro area exposure via merchandise exports, cross-border bank claims and portfolio assets.

1) Net of intra-euro area exposure.

2) As a percentage of total merchandise exports in 2012.

3) As a percentage of total cross-border bank claims as at the third quarter of 2013; data for the euro area include Belgium, Germany, Greece, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland.

4) As a percentage of global assets in 2012.

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(3.8%) and Turkey (3.3%) constituting a large share of the total. An outlier in this respect is China, which takes 7.0% of euro area merchandise exports.

Among the countries that were considered most vulnerable by investors during 2013 and that consequently witnessed a substantial deterioration in their economic and financial conditions, only Turkey and Brazil account for significant shares in the euro area’s exposure to emerging markets, via trade (Turkey) and cross-border bank flows (Brazil and Turkey). The shares of India, Indonesia and South Africa are very small.

UNiTEd STATES

The recovery in the US economy continued in 2013, although at a slower pace than in the previous year. Real GDP growth stood at 1.9%, compared with 2.8% in 2012. Growth in 2013 was supported by a strengthening in private domestic demand, reflecting continued improvements in the housing and labour markets, supportive financial conditions resulting in positive wealth effects from rising stock and house prices, and accommodative monetary policy. In addition, inventory accumulation and, to a lesser extent, net trade also contributed positively to real GDP growth. The current account deficit narrowed to 2.4% of GDP in the first three quarters of the year, from 2.7% in 2012.

By contrast, higher taxes, as enshrined in the fiscal agreement of January 2013, and the automatic across-the-board spending cuts (the “sequester”) enacted in March, remained a drag on economic activity throughout the year.

In the first half of the year economic activity remained sluggish, against the backdrop of continued declines in government consumption related to the aforementioned government spending cuts, subdued private non-residential investment and weak exports. Nevertheless, private consumption expenditure was resilient during the same period, with higher taxes and sluggish income growth being more than offset by an improvement in the labour market and substantial positive wealth effects owing to rising stock and house prices. Private residential investment also remained quite robust on the back of a resilient recovery in the housing sector. Real GDP accelerated in the second half of 2013, with particularly strong growth in the third quarter. Economic activity, however, lost some momentum towards the end of the year on account of two main factors. The increase in long-term interest rates, starting in May, when the Federal Reserve suggested it might slow the pace of asset purchases later in the year, resulted in a tightening of financial conditions, which dampened somewhat the housing market recovery. In addition, the government shutdown following the political brinkmanship over the debt limit extension in October, with the associated rise in uncertainty, weighed on domestic demand. Meanwhile, labour market momentum remained quite resilient in the second half of 2013, although the year ended with a substantial deceleration in the pace of job creation, partly reflecting severe weather conditions in December. The unemployment rate continued to trend down in the course of the year, owing partly to continued declines in the labour force participation rate.

Average annual CPI inflation declined to 1.5% in 2013, from 2.1% in 2012, owing to lower energy prices and considerable spare capacity, which kept underlying price pressures contained. In the first half of 2013 CPI inflation hovered between 1.1% and 2%, affected by substantial volatility in the energy component, while food prices exhibited a slightly downward trend. Through most of the second half of 2013, annual CPI inflation declined as the strong positive base effects of energy prices waned. Excluding food and energy, CPI inflation stood at 1.8% in 2013, after 2.1% in 2012.

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The US Federal Open Market Committee (FOMC) of the Federal Reserve System kept its target for the federal funds rate unchanged within a range of 0% to 0.25% throughout 2013, in an environment of moderate economic and employment growth and inflation running below the Committee’s longer-term objective. The FOMC announced that exceptionally low levels for the federal funds rate would be appropriate at least as long as the unemployment rate remained above 6.5%, inflation between one and two years ahead was not projected to be above 2.5% and longer-term inflation expectations continued to be well anchored. The FOMC decided to continue purchasing additional agency mortgage-backed securities at a rate of USD 40 billion per month and longer-term Treasury securities at a rate of USD 45 billion per month. Furthermore, the Committee maintained its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage- backed securities. With these actions, the FOMC expected to maintain downward pressure on longer-term interest rates with a view to supporting mortgage markets and to help make broader financial conditions more accommodative. In June the FOMC reaffirmed Chairman Bernanke’s remarks before the US Congress Joint Economic Committee in May that, later in the year, the FOMC could slow the pace of asset purchases should the economy continue to improve as expected.

It stated that it expected its asset purchase programme to end in mid-2014. Nevertheless, taking into account the extent of federal fiscal retrenchment in the period to September and the prevailing fiscal policy uncertainty, the Committee announced in September that it would wait for more evidence of sustained progress in economic activity and labour market conditions before adjusting the pace of its asset purchases. On 18 December the Committee decided to ease the pace of its asset purchases slightly, given the cumulative progress towards maximum employment and the improvement in the outlook for labour market conditions. The FOMC announced that, from January 2014 onwards, it would add to its holdings of agency mortgage-backed securities at a rate of USD 35 billion per month, rather than USD 40 billion, and to its holdings of longer-term Treasury securities at a rate of USD 40 billion per month, instead of USD 45 billion. The Committee stated that it would likely reduce its asset purchases in further measured steps at future meetings, conditional on the FOMC’s assessment of economic developments.

As regards fiscal policy, the federal budget deficit declined significantly to 4.1% of GDP in fiscal year 2013, from 6.8% in the previous year.² Federal debt held by the public increased to stand at 72.1% of GDP at the end of 2013, compared with 70.1% at the end of 2012. A large part of the reduction in the fiscal deficit in 2013 was due to a political agreement on tax and spending reforms (the American Taxpayer Relief Act) in early January, which mainly included revenue- raising measures, and to the across-the-board spending cuts enacted in March. However, political uncertainty over the most appropriate fiscal path persisted throughout the year. Political and fiscal uncertainty reached a peak in October, stemming from the partial shutdown of non-essential government services, coupled with political brinkmanship over the extension of the debt limit.

Although a political deal was reached to keep the government funded and the debt limit suspended to avoid a government default, fiscal uncertainty continued to cloud the short-term economic outlook. On 26 December 2013 President Obama signed into law a bipartisan budget deal to end some of the spending cuts under the sequester by raising the caps on discretionary spending for the next two fiscal years, replacing them with other sources of saving spread over ten years.

jAPAN

In Japan, economic activity rebounded during 2013, mainly driven by robust domestic demand.

While growth was vibrant in the first half of the year, it lost momentum thereafter as net exports weighed on growth and private consumption slowed. In 2013 economic growth was supported by a

2 Fiscal years in the United States run from October of the previous year to September of the reference year.

ANNUAL REPORT 2013

2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013

ANNUAL REPORT

2013

ANNUAL REPORT 2013

CONTENTS

ABBREviATiONS

FOREwORd

ChAPTER 1

ECONOmiC dEvELOPmENTS ANd mONETARy POLiCy

1 mONETARy POLiCy dECiSiONS

2 mONETARy, FiNANCiAL ANd ECONOmiC dEvELOPmENTS